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Shares of Norfolk Southern Corporation (NYSE:NYSE:NSC) have beaten the S&P 500 by wide margins over the last five and ten years. Furthermore, Norfolk Southern’s dividend has a low payout ratio and a double-digit growth rate. Add to that a manifestly impenetrable moat, and you have the makings of an ideal dividend growth investment.
Of course, even the best of companies have at least a handful of negatives to consider. Among the major railroads, NSC is the most dependent on coal shipments. Furthermore, the company is sensitive to macroeconomic conditions. Last but not least, American railroads could face a nationwide strike within a few days.
Norfolk Southern – An Overview
With approximately 19,300 miles of railway, Norfolk Southern is the fifth largest North American railroad. Serving every major container port in the densely populated eastern U.S., NSC also has operations in or around every major eastern city.
Intermodal railcars are the company’s largest revenue source. Providing 28% of total revenue when adjusting for fuel costs, Norfolk’s intermodal freight recorded 22 consecutive quarters of year-over-year growth. Intermodal revenue surpassed coal in 2014, and now comprises approximately 60% of volume. Keep in mind that time frame includes a freight recession and the pandemic.
The second largest freight category, contributing 20% of revenues, includes agriculture, forest, and consumer products. Chemicals, which comprises refinery products, fracking sand, and crude oil, provide 18% of revenues. Construction materials, metals, and minerals generate 14% of revenue, and coal 12%. Automotive, which encompasses finished vehicles as well as parts, provided 8% of 2021 revenue.
NSC’s revenue grew a solid 14% in FY 2021, and last quarter, Norfolk Southern reported a 16.11% increase in revenue, year-over-year. This was despite a 3% decline in total volume.
Operating expenses were up 21%, largely due to an increase in fuel costs.
For FY22, management guides for a high-single-digit year-over-year sales growth, and for flat volume for the remainder of the year.
Headwinds
A chief factor when evaluating NSC as an investment relates to uncertainty in the macroeconomic environment. As noted earlier, fluctuating fuel prices should be considered, as two-thirds of last quarter’s increase in operating expenses were attributed to higher fuel costs.
Rail carriers are also highly sensitive to the macroeconomic environment. While strong manufacturing activity boosted revenues of late, the outlook is cloudy moving forward.
Among the major rail lines, NSC is the most exposed to coal. Therefore, over the long term, a decline in coal volumes will work against the company.
Hiring and retention headwinds (more on that topic later) continue to drag on Norfolk’s opportunity to build on recent strong industrial and intermodal freight demand.
To some extent, railroads base their rates on the prevailing costs for truckers. The goal is to raise or lower rates while always keeping a pricing gap between the two forms of transportation, thereby making rail lines the more affordable option.
Trucking capacity has been increasing of late. A recent study by BofA has trucking capacity at its highest level since June of 2020, with shippers’ forecast for freight rates falling to the lowest level since July of 2020. Consequently, investors should expect the rates charged by rail lines to also fall.
Tailwinds
NSC anticipates volume improvement for international and domestic intermodal in the second half of 2022. Management believes demand will remain strong while service improvements should allow for increased throughput on the railroad’s network.
U.S. light vehicle production served as a headwind in 2021, largely due to chip shortages. With semiconductor supply improving, Norfolk guides for automotive production to be up 18% over the levels experienced in the last six months of 2021.
Despite a 4% decline in volume, coal segment revenue was up 34% year-over-year last quarter due to a 39% increase in pricing. NSC anticipates a rebound in coal from demand related to steel production and global energy needs.
One long term positive lies in railroads low emissions. With ESG and government regulations driving carbon emissions, it should be noted that 80% of greenhouses gas stem from transportation. Railroads are four times as fuel efficient as trucks. Consequently, companies seeking to improve ESG scores may opt for rail lines to meet their transportation needs.
The American Trucking Association (“ATA”) forecasts “continued growth in freight demand across all modes for the foreseeable future.” ATA forecasts total freight tonnage will surge from 15.1 billion tons in 2021 to 19.3 billion tons in 2032, a 28% increase.
Total U.S. revenue from freight shipments is estimated to increase from $1.083 trillion in 2021 to $1.627 trillion in 2032.
A Moat Wider Than The Mississippi
It is hard to imagine a business with a wider moat than the likes of NSC. I always consider a company’s status as a member of an oligopoly as a strong positive, and a wide moat is obviously desirable. NSC possesses both of these attributes in spades.
Aside from shipping, railroads are by far the lowest cost means of freight transportation. Obviously, the routes waterborne freight can take are limited, so in a sense, the two modes of transportation do not compete directly against each other.
Railways consume up to 9x less energy per tonne kilometer traveled than trucks, and are around four times as fuel efficient. Trains can move one ton of freight an average of 479 miles on a single gallon of fuel. This gives railroads an enduring cost advantage, allowing rail operators on the east coast to charge 10% to 20% less than truckers.
The capex required to replicate the major railroads infrastructure would be enormous, meaning there is literally zero chance of new competition.
Precision Scheduled Railroading And A Potential Strike
Precision Scheduled Railroading (“PSR”) was first introduced in 1993. Without getting too deep into the weeds, PSR emphasizes point-to-point freight car movements on simplified routing networks.
Rather than being operated separately as in the past, container and general merchandise trains are combined as needed. A hallmark of the strategy are freight trains that operate on fixed schedules rather than being dispatched when a sufficient number of loaded cars are available.
There is no doubt that PSR lowers costs: however, one reason for the more profitable operations is a greatly reduced employee headcount. In addition to employee cuts related to the implementation of PSR, railroads also dropped head counts due to the pandemic.
According to the Bureau of Labor Statistics, rail employment levels are now 20% below 2019. The Surface Transportation Board estimates railroads slashed 29% of their workforce over the past six years. All of the major railroads are now scrambling to recruit employees.
PSR has led to NSC lowering its compensation expense ratio from 28% of revenue in 2016 to 22% of revenue in 2021. In that time frame, Norfolk’s employee headcount has dropped from 28,000 to 18,500. Even so, it ranks as the firm’s largest single expense.
However, there is a major negative associated with PSR, and that relates to employee morale. Rail workers are ground down by a system that requires that employees remain at the beck and call of the company to ensure that the “trains run on time.”
After more than two years of disputes between the railroads and labor unions, we are potentially within a few days of experiencing a railroad strike. A study by the Association of American Railroads claims a strike would cost the U.S. economy $2 billion a day.
The railroad has brought its labor woes on itself. They have made steep staffing cuts to appease shareholders and improve their bottom line. Workers are burned out. You have heard from the railroads they are hiring but they are not retaining talent because of the point system where you are on call for 12 hours a day and you have to be an hour or less away from your job. They are being held hostage.
– per a labor insider with knowledge of the negotiations
President Biden created a Presidential Emergency Board (“PEB”) to help negotiate an agreement between the warring parties. However, as of this date, only ten of the twelve unions have reached a tentative agreement with the carriers.
The PEB recommended an immediate 14.1% wage increase, a 24% compounded wage increase from 2020 through 2024 and an additional day of paid leave. However, a deal with each of the twelve unions must be reached to prevent a work stoppage.
One potential stumbling block is that the holdout unions demand quality-of-life improvements. Currently railroads require employees to be on-call and available to work most days.
The Railway Labor Act gives both sides until midnight on Friday to come to an agreement. After that union members can go on strike.
However, Congress has the authority to avert a railroad strike. In 1986, Congress issued a no-strike rule for 60 days to extend negotiations related to the Maine Central Railroad Union strike. In 1991, Congress ended a national railroad strike less than twenty four hours after it began.
Debt, Dividend, And Valuation
NSC is rated in the lower end of investment grade by the credit agencies.
The current yield is 1.98%, the payout ratio is a bit above 37%, and the 5 year dividend growth rate is 14.73%.
NSC currently trades for $243.30 per share. The average one year price target of the 17 analysts rating the stock is $283.10. The price target of the two analysts that rated the stock following the most recent earnings report is $279.50.
Norfolk has a forward P/E of 18.21x, well below the average P/E ratio for the stock over the last 5 years of 21.19x.
NSC has a 5 year PEG of 2.06x, as opposed to the 5 year average PEG ratio of 1.74x.
Is NSC Stock A Buy, Sell, Or Hold?
I doubt one can find a company with a wider moat than that of NSC. Aside from the current struggles with labor, there are few negatives associated with an investment in this railroader.
One can point to the dwindling demand for coal, as well as the current macroeconomic climate as headwinds. However, the loss of revenue from coal is evolving slowly, and a recession should be a transitory problem.
NSC has a reasonable debt level, the company has fairly strong growth prospects, and the firm’s history of dividend growth provides a large, sweet target for those seeking a passive income stream.
Unfortunately, I do not see the shares as trading with the margin of safety I seek. Consequently, I rate NSC as a HOLD.
I would add; however, that should workers launch a strike, we would likely see the shares drop markedly, perhaps providing an entry point for a long-term investor.
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